What They Are Doing

The Euro
and You described a fundamental problem of world finance. The quantity
of debt grows as the quality recedes. The problem of bad loans is no longer
just the pre-2008 mortgages, CDOs, and LBOs. Debt issued after the bust
is defaulting, such as Greek sovereign bonds, issued in June 2010. Some
securities are born to part investors from their money, but it's remarkable
the extent and variety of such instruments issued in 2011. The world choked
on similar bonds and derivatives only three years ago, many of which are
still held at false prices on financial institutions' books.

Of all the past century's downgrades, none has been greater than the borrower's
promise that stands behind a "security," a word that once credibly described
a paper contract backed by appropriate collateral. In Debt and Delusion,
Peter Warburtin wrote: "It is easy to forget that, as recently as in the 1960s,
the government budgets of the OECD countries were in approximate balance and
that net issues of debt were comparatively rare. The outstanding stock of
debt in public hands was a meager $800 billion at the end of 1970. At that
time debt issue was typically reserved for the financing of large construction
projects or investment by power generation companies by publicly owned companies." Today,
PIMCO's Bill Gross manages $244 billion in a single bond fund.

The starting pistol was sounded on August 15, 1971, 40 years ago. On that
date, the United States broke its long-standing promise to pay one ounce of
gold to a foreign government that redeemed $35 for the same. (The ability
of American citizens to redeem dollars for gold with the U.S. government was
modified during World War I and ceased after the War.) As a prelude to the
loosy-goosy financial contracts today, it is worth reviewing the wording of
the contractual relationship between the United States government and the
holder of its currency before and after. (A book should be written on the
parallels between the century-long degradation of language, the American legal
system, money, credit, debt, and the American people.)

The face of a $20 bill, a gold certificate, issued in 1882, stated: "This
certifies that there have been deposited in the Treasury of the United States,
twenty dollars in gold coin, repayable to the bearer on demand." The bearer
of $20.67 received one ounce of gold in exchange. This is a simple legal contract.
It is easy to understand. There was no theory. No economists were employed
to interpret what did not require interpretation.

A 2011 Federal Reserve Note states: "This note is legal tender for all debts,
public and private." As contracts go, this makes no sense. Nor does it make
sense to a three-year-old. My extensive survey of three-year-olds did not
uncover a single child, who, in exchange for a $20 bill, preferred another
$20 bill rather than receive a one-ounce gold coin. (The current value of
the one-ounce coin versus that of the $20 bill is not germane to this survey.)

The abstraction of money is related to the manner in which securities today
are often backed by abstract or non-existent collateral. Contradictory theories
employ at least 100,000 economists (probably multiples of this figure), among
whom, there may not be a handful who ever write or think about money. Read
(if you must) the theoretical papers or newspaper columns of these imposters.
They retreated into a soothing bubble bath of differential calculus generations
ago.

Many of the malignant securities issued in 2010 and 2011 have fallen into
disfavor. Credit markets have suffered loss of liquidity, momentary or protracted.
These issues, collateralized by hope and imagination, are on the books though,
often at institutions that already hold wads of securities still valued at
wishful prices (for purposes of accounting, capital requirements, and falsifying
the institutions' dubious solvency). We should expect that when Federal Reserve
Chairman Ben Bernanke revs up his money machine, more will flow.

It is a safe bet that Ben is preparing to welcome more unmentionable securities
on the Fed's balance sheet. ("Federal Reserve officials are starting to build
a case for a new program of buying mortgage-backed securities to boost the
ailing economy...." - Wall Street Journal, October 21, 2011.)

Guessing at why the Fed will splurge is a chicken-or-egg game. Is the Fed
preparing for a downdraft in the stock market with its tried-and-false response:
by creating more money? Or, is it preparing to transmit (by electronic keystroke)
more dollars to absorb securities held at banks, insurance companies, money-market
funds, and mutual funds that should be carried at a much lower value?

The Fed washed its hands of credit analysis on January 6, 2011, when it issued
its weekly H.4.1 "Factors Affecting Reserve Balances." The federal agency
that vaunts its "transparency" (i.e.: the Fed) implanted a note that transferred
all capital losses to the taxpayer. The January 6, 2011, "Factors Affecting
Reserve Balances" stated that beginning on January 1, 2011, all capital losses
in the Federal Reserve's mangy and non-transparent portfolio would henceforth
be transferred to the Treasury Department. In a sense, this is only an accounting
frivolity, since the taxpayer ultimately pays for the New York Fed's reckless
mismanagement of its highly leveraged portfolio (103:1); that could soon,
absent the January 6 sleight-of-hand, mirror Enron's jambalaya.

After the 2008 credit meltdown, the Fed, led by Simple Ben, fought for greater
regulatory control of the banking system. The cranks who warned against Federal
Reserve regulatory authority have been vindicated, on a comically inflated
scale.

Wild-and-wooly securities that cratered after the credit cycle turned (circa
2007) are back, for instance: low doc, cov lite, payment-in-kind toggle notes,
the proceeds of which pay private-equity firms up-front dividends. Century
bonds (Mexico, the University of Southern California) sold swiftly, never
a good sign. "Synthetic junk bonds" warned the Financial Times that "resemble
transactions linked to U.S. mortgages, which proliferated before the crisis" and "staple
deals" counseled the Wall Street Journal that "came under sharp criticism
during the buyout boom for causing a number of conflicts of interest" have
been structured by the banks that Ben Bernanke regulates. This highlights
the greatest conflict of interest: the false claim that the Federal Reserve
regulates the banks.

One security in the pipeline (possibly on hold during the current market mayhem)
is a "synthetic deutsche mark," that would "create shadow trading in legacy
currencies in a synthetic market." Paul Volcker said somewhere the only financial
advancement of the past 30 years is the ATM card. Comparing the collateral
behind Peter Warburtin's bond market to the absence of such behind the synthetic
deutsche mark (a currency that ceased to exist over a decade ago) outlines
the enormous waste of capital, human ingenuity, and savings over the past
40 years. With nothing learned, this will continue, until uncollateralized
paper spawns a New Era in post-fiat origami.

Sheehan serves as an advisor to investment firms and endowments. He is the
former Director of Asset Allocation Services at John Hancock Financial Services
where he set investment policy and asset allocation for institutional pension
plans. For more than a decade, Sheehan wrote the monthly "Market Outlook" and
quarterly "Market Review" for John Hancock clients.

Sheehan earned an MBA from Columbia Business School and a BS from the U.S.
Naval Academy. He is a Chartered Financial Analyst.